A Danger Lurking in the Shadows

An unaddressed cause of the 2008 financial crisis was banks' reliance on elaborate schemes called repurchase agreements, or "repos," to fund their operations. Four years later, usual suspects like Goldman Sachs, JPMorgan Chase and Bank of America remain heavily dependent on them, endangering the financial system, as shown in a new Public Citizen report, "The Repo Ruse."

Repos, often associated with the largely unregulated "shadow banking" system, are loans dressed up to look like sales. In a repo agreement, the borrower, for example Goldman Sachs, "sells" an asset (such as a bond) to another party, for example a money market mutual fund. The borrower also agrees to buy back the asset, often the next day, paying a little bit more as "interest." These sales and buybacks continue on and on until one party decides to end the agreement.

So why do the parties choose to engage in such contractual gymnastics instead of just agreeing to a conventional loan? There are two big reasons, both of which create excessive risk.

First, Congress has carved out a special exemption for repo transactions from the usual requirements of federal bankruptcy law. Traditionally, if a borrower goes bankrupt, the lender has to compete with other creditors in the bankruptcy process to recoup its investment. Not so with repo agreements. Congress has accepted the buy-and-sell charade of repos and affirmed that repo lenders can sell collateral immediately if repo borrowers go bankrupt. This permission makes repo lenders more willing than normal creditors to engage in sloppy lending practices, and more likely to dash for the exits at the first sign that their borrowers are in trouble--imperiling individual institutions and potentially triggering market panics.

Second, the fiction that repo borrowers "sell" the assets that serve as collateral permits them to cover up problems on their balance sheets.

The demises of Bear Stearns and Lehman Brothers in 2008 perfectly illustrate the dangers. Bear Stearns relied on enormous sums of repo money that it borrowed, using securitized mortgages as collateral. When the housing market began falling, its counterparties effectively pulled their repo funding. Only a government-brokered deal saved the firm from bankruptcy.

Tremors from the Bear episode prompted the Federal Reserve to take unprecedented steps in an attempt to ward off a panic. It established an alphabet soup of new programs, two of which were created to lend to repo-dependent firms. Those two programs accounted for a cumulative total of $11 trillion in Fed loans, according to research conducted by James Andrew Felkerson, a graduate student under the direction of Levy Scholar L. Randall Wray at the University of Missouri-Kansas City.

But even those trillions could not save Lehman Brothers, whose September 2008 bankruptcy declaration marked the watershed moment in the financial crisis. Lehman Brothers had exploited the buy-and-sell fiction of repo transactions to remove toxic assets from its balance sheet and replace them with cash, which it then used to pay down debts.

Although the specific loophole that Lehman used has been closed, financial firms continue to exploit this scheme in other ways. One highly publicized example occurred at MF Global, the investment firm run by former Sen. (and Goldman Sachs alum) Jon Corzine (D-N.J.) that went bankrupt last year. MF Global engaged in repo "sales" to hide toxic European debt from its balance sheet. When the firm's deception was revealed, its repo lenders effectively withdrew their money, rendering MF Global insolvent.

Not everybody is blind to the threats posed by repos, or the damage that they've already inflicted. Thomas Hoenig, a director of the Federal Deposit Insurance Corporation and former president of the Kansas City Federal Reserve bank, called in Senate testimony earlier this month for ending special bankruptcy treatment of mortgage-related repurchase agreements. "One of the sources of instability in the crisis was repo runs," Hoenig warned the Senate Banking Subcommittee on Financial Institutions and Consumer Protection.

Other regulators and Congress would do well to listen to Hoenig's advice on reforming the repo market. Until they act, the financial system will remain exposed to the repo danger that lurks in the shadows.

This post was co-written by Micah Hauptman and Taylor Lincoln of Public Citizen's Congress Watch division.